Wednesday, December 2, 2020

Startup Cap Table 101: Introducing an Equity Compensation Pool

 I have to admit: cap table calculations are not easy and not all startup lawyers enjoy this part of their jobs.  However, no matter how hard it can get, being able to make sense of the cap table is an essential skill for startup lawyers.  Since I have just finished teaching this to students at Fordham Law's Entrepreneurial Law class, I thought I would share some of the calculations here with you.  

Let's start with your basic cap table:

                            Stock Type        Shares        Fully Diluted Stock %
Founder A            Common        1,000,000        50%
Founder B            Common        1,000,000        50%
Totals:                                         2,000,000       100%    

This example shows that the startup has two founders, each holding 50% of the issued and outstanding stock.  BTW, this startup has authorized 5,000,000 shares of common stock, $0.00001 par value.

The Board of Directors has just approved the issuance of an equity compensation pool of 20%.  The stockholders of the company (ie, both founders) have also unanimously approved the pool.  Now, let's reflect it in the cap table:

First, let's find out how many shares will be allocated to the pool.  To get there, we use the following formula: 

Total New Shares Outstanding = Existing shares outstanding / 1 - options pool %, which means: 2,000,000 shares / 0.8 = 2,500,000 shares.  So, with the pool, the startup will have 2,500,000, which means that the pool will have 500,000 shares of common stock allocated to it.  Our cap table now looks like this:

                            Stock Type        Shares        Fully Diluted Stock %
Founder A            Common        1,000,000        40%
Founder B            Common        1,000,000        40%
Pool                      Common        500,000           20%
Totals:                                         2,500,000       100%    

As you can see, the creation of the pool diluted both founders.  Obviously, if the pool were to be created after an equity financing event, it would dilute both the investors and the founders.  That's why investors always want the pool shares to be created on a pre-money basis, diluting the founders alone.  

In the next blog post, let's look at how to add a Series A financing to this cap table.

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